It is a fast-moving political landscape. At the weekend world leaders met at the G20 in Buenos Aires. The most notable takeaway for the world economy and the markets was news of a productive meeting between Presidents Trump and Xi. This has put a halt to any new year escalation of the trade war, with previously announced hikes in tariffs now being put on hold.
It remains to be seen whether this good news is temporary or permanent, but at least it suggests a serious attempt to prevent an escalation of tensions. These were already leading to forecasts of world growth being revised down, with negative implications for earnings expectations.
As for the other big political event, the approach of the December 11th vote in the House of Commons on the Prime Minister’s Brexit deal, there remains considerable uncertainty as raw politics takes centre stage.
Don’t panic – that might be the best message to take away from the last week in the UK.
It is hard to quantify fully the political risk premium that is now attached to UK assets, but it is most apparent in sterling’s soft performance and looks set to persist until there is clarity about the Brexit outcome.
There are many different options about what could happen on December 11th, with an almost universal view among political observers that the Prime Minister’s plan will not be approved by Parliament on the first reading, meaning she will then be expected to go back to Brussels to seek concessions. After that there may be a second reading of it based on any revised deal.
Of course, a heavy defeat could unleash other scenarios, even a vote of no confidence, leadership change or a general election. In the absence of new legislation or an election, a No Deal is the default option, although most in Parliament want to avoid that.
Uncertainty persists – even in the choice of options
This sequence of possible events gives extra weight to the six amendments that the Speaker will allow to be voted on before the PM’s withdrawal agreement. In themselves these do not determine the outcome but clearly if any is passed it could influence the turn of events. There is uncertainty as to whether any other options might be accepted, and what the consequences might be.
The expectation is that only one of these six may pass – which seems strange as we don’t know what these all are yet. Also, the one that it is said may pass, the Norway Option, has not proved popular before. When the House of Lords backed a Norway option in the summer and sent it back to the Commons it was then defeated by over 200 votes. Expect uncertainty to persist.
The PM’s deal points to a smooth exit, followed by a transition, and this might result in a deal dividend, helping near-term investment, but it comes with the challenge that it will constrain future UK policy considerably.
Two distinct scenarios, one common thread
To inform the wider debate, over the last week we have seen scenarios from both the Treasury and Bank of England. While distinct, there was a uniformity to what both said: a severe economic setback if the UK leaves the EU without a deal. Of course, much would depend in that scenario on how much preparatory work has been done, covering areas such as mutual recognition agreements and statutory instruments.
The trouble is, this is opaque. The suspicion is that not enough has been done to ensure a smooth transition. Of course, if the UK takes this route, it already trades with about 112 countries under World Trade Organisation terms and would be able to use as its initial schedules the present terms it has now, as a member of the EU.
The Treasury’s forecasts for the next 15 years pointed to the UK being a low growth, wage and productivity economy in all outcomes, even remaining in the in EU. The media focus was on the differences between the various paths, with the official view being that remaining in the EU was the best for economic growth. The Bank of England’s scenarios, meanwhile, were over five years.
A forecast is a prediction or estimate of a future event or trend, such as the rate of growth of GDP, while a scenario is a postulated sequence of events. The margin of error on an economic forecast can sometimes be high. This has been evident even over a one-year forecast horizon, as we have seen in the UK in recent years, never mind over a fifteen-year forecast such as that made by the Treasury.
Moreover, the other key aspect of such forecasts are the assumptions on which they are built. If a negative view is taken of trade costs, as was evident, that lowers the final growth forecast. Also, it is assumed that policy will not change – but as we see all the time, in all countries, macro policy does react to changing economic circumstances.
Meanwhile, the Bank of England provided different scenarios, based on worse case assumptions about what lay ahead. The trouble, of course, is that if a central bank warns of a currency collapse and economic weakness this has the danger of becoming self-fulfilling, denting business confidence and impacting market expectations. Sterling has certainly looked softer in the aftermath.
A combination of policies could dampen growth
While the media focused on the Bank of England’s Brexit scenarios, away from these it is the Bank’s current policy that should raise concern about the economy’s current performance. The economy is slowing, and over the last year has seen a small hike in interest rates, a withdrawal of lending schemes, early stage quantitative tightening, as well as an increase in the counter cyclical capital buffer for banks. While in isolation each of these actions may appear small, in combination they may dampen economic growth, and to this we need to add in the present political and Brexit uncertainty.
The Fed has had the biggest impact on markets
Looking further afield, the US central bank, the Federal Reserve (the Fed), has had the biggest impact on markets. Minutes from the Fed’s November meeting showed a clear bias to tighten, with a view that a further interest rate hike was “likely to be warranted fairly soon”, with flexibility on the degree of tightening thereafter, dependent upon the data. However, the day before such minutes were released, markets reacted to a more dovish tone from Fed Chairman Powell.
Much depends upon where the Fed sees equilibrium interest rates, otherwise known as r star (r*). The current target range for the Fed funds rate is 2% to 2.25%, whereas estimates for r* are 2.5% to 3.5%. The Fed is seen as moving towards r*. But measures of r* are also likely to change over time.
This has been seen previously in key economic policy issues, such as the natural rate of unemployment, as well as the output gap. At various times the consensus focused on particular figures or ranges for both; in time, however, such precision was shown to be wide of the mark and history showed that the natural rate of unemployment moved and that output gaps have been revised significantly.
Based on that, there is a need to keep an open mind about where r* is, in the US, or indeed in the UK. In the US, and the UK, it is the economic data that will set the direction of travel, for policy and for the markets. Currently these point to the Fed still tightening further, gradually.
Meanwhile, in the UK, the timing and path of interest rates will depend heavily on how the present economic and political uncertainty unfolds.
Please remember that when investing your capital is at risk.